Pages

Friday, August 29, 2008

Previously I noted that globalization may the catalyst that brings real reform to U.S. health care. According to an article in the City Journal, another glimmer of hope may be found in "health care's new entrepreneurs":

For seriously ill patients, American health care is second to none. Our commitment to innovation is unmatched; our researchers have won more Nobel Prizes for medicine than all other countries’ combined; our biotech and pharmaceutical industries, thanks partly to lavish federal funding for basic science research, are the envy of the developed world. So lopsided is the field that thousands of European scientists have relocated to companies in the U.S., where they have a better chance of transforming cutting-edge research into lifesaving new medicines.

But American health care is also much more confusing, impersonal, and expensive than it needs to be. Conflicting opinions from doctors and insurers often strand patients with complex diseases in a medical maze. Many primary-care physicians, frustrated with red tape and puny reimbursements, limit the number of Medicare and Medicaid patients whom they see, or they drop out of the profession altogether. Adding insult to injury, employers and employees face seemingly endless cost increases, with health-insurance premiums rising much faster than inflation or income.

Thankfully, entrepreneurs are finding ways to bring innovative, consumer-oriented health care to market—simplifying medical decisions, reinvigorating primary care, and lowering health-care costs. From health insurance to DNA-driven medicine, American health care is experiencing a revolution from below that promises to improve quality, lower costs, and empower people to control their own health care.

Sunday, August 24, 2008

That is my new name for Willem Buiter who boldly challenged the Federal Reserve and its policies at one of its own meetings. Buiter presented a paper that was very critical of the Fed's actions leading up to, during, and after the housing boom-bust cycle at the Fed's annual Jackson Hole, Wyoming retreat. The Wall Street Journal and Bloomberg both report his paper generated a heated debate at the meeting. Coming to Buiter's rescue in the blogosphere is Yves Smith while Mark Thoma sides with the Fed. I have only scanned his paper (144 pages!) , but here is a section from it that summarizes his critique of the Fed:

I argue that three factors contribute to Fed’s underachievement as regards macroeconomic stability. The first is institutional: the Fed is the least independent of the three central banks and, unlike the ECB and the BoE, has a regulatory and supervisory role; fear of political encroachment on what limited independence it has and cognitive regulatory capture by the financial sector make the Fed prone to over-react to signs of weakness in the real economy and to financial sector concerns.

The second is a sextet of technical and analytical errors: (1) misapplication of the‘Precautionary Principle’; (2) overestimation of the effect of house prices on economic activity; (3) mistaken focus on ‘core’ inflation; (4) failure to appreciate the magnitude of the macroeconomic and financial correction/adjustment required to achieve a sustainable external equilibrium and adequate national saving rate in the US following past excesses; (5) overestimation of the likely impact on the real economy of deleveraging in the financial sector; and (6) too little attention paid (especially during the asset market and credit boom that preceded the current crisis) to the behaviour of broad monetary and credit aggregates.

[...]

The third cause of the Fed’s macroeconomic underachievement has been its tendency to use the main macroeconomic stability instrument, the Federal Funds target rate, to address financial stability problems. This was an error both because the official policy rate is a rather ineffective tool for addressing liquidity and insolvency issues and because more effective tools were available, or ought to have been. The ECB, and to some extent the BoE, have assigned the official policy rate to their price stability objective and have addressed the financial crisis with the liquidity management tools available to the lender of last resort and market maker of last resort.

Yves Smith says points 1 and 3 are valid, but 2 is debatable. It will be interesting to see what other observers say on these points. On a different note, I found interesting his suggesting for addressing asset bubbles:

Therefore, while I agree with the traditional Greenspan-Bernanke view that the official policy rate not be used to target asset market bubbles, or even to lean against the wind of asset booms, I do not agree that the best that can be done is for the authorities to clean up the mess after the bubble bursts...[Rather,] [c]ountercyclical variations in capital and liquidity requirements [or] an automatic financial stabiliser [is needed.]

This is something to consider, but I submit that a nominal income targeting rule would go far in avoiding the formation of asset bubbles in the first place. But I digress. This is a provocative paper that should fuel debate for some time to come.

Thomas Friedman argued in "The World is Flat" that one reason that the 2001-2002 India-Pakistan standoff did not turn into a war--a potentially nuclear one at that--was because of the influence of foreign investment in those countries. These foreign investors more or less threatened to pull out their current and any future investments should war break out. So no war broke out and diplomacy ruled the day. I am sure there were many other factors in the mix, but Friedman's interpretation makes for a great story on the positive externalities created by globalization. I mention this because this past week Daniel Gros had a similar take on the Russian-Georgian conflict:

Russia's occupation of Georgia and the U.S. signing of a missile-defense deal with Poland have grizzled Cold Warriors partying like it's 1979.... But don't go dusting off your copies of George Kennan's "X" Foreign Affairs article and NSC 68 just yet. It's going to be a lot harder to have a Cold War between Russia and the West in 2008 than it was in 1948.

During the Cold War (this is for all the under-40 set), the world was to a large degree divided between the Communist world—the Soviet Bloc and China—and the free world. And while there were exchanges and a limited amount of trade (in the 1970s, Pepsi began bartering Pepsi-Cola for Stolichnaya vodka, and the United States exported grain to the Soviet Union), commercial ties between the Eastern Bloc and the West were extremely limited.

Today, nearly 20 years after the fall of the Berlin Wall, Russia may not be a free-market paradise. But it has evolved into an important part of the global trading system and has built deep, enduring, and significant economic ties to the West. As a result, the implications of increasing tensions are as much economic as they are geopolitical. And a renewed chill between Moscow and Washington will trouble the sleep of CEOs as much as it will agitate peaceniks. On the other hand, the close economic ties make it less likely that political tensions will erupt into actual warfare since the executives in Moscow and New York (and London, and Frankfurt, and Milan …) will be lobbying for peace.

I hope he and Friedman are correct. One has to remain cautiously optimistic on this point, though, since similar arguments were made during the last great globalization wave just prior to the outbreak of World War I (See Krugman).

Tuesday, August 19, 2008

What explains the sustained nature of low inflation in the advance economies--and to a lesser extent in the emerging economies--since the end of the 'Great Inflation'? William White has a recent paper that takes a looks at this question. In it, he evaluates the standard reasons given for the ongoing low inflation: (1) better monetary policies, (2) increased deregulation and competition in domestic markets, (3) increased globalization, and (4) a global saving glut. White concludes that no one reason can explain the sustained drop in inflation. He does, however, believe that a broader story that involves these factors acting in a complimentary manner can explain the facts. Interestingly, he weaves a story using these factors with the help of an IS/LM model that has a vertical full employment line, such as the one used in the Abel/Bernanke/Croushore textbook:

Perhaps the key to a better understanding is to recognise that the character of the shocks hitting the global economy has changed over time, and that some forces affecting inflation have been more important at some times than others. Demand side factors, driven largely by domestic monetary policies, seem to have been central to macroeconomic developments in the 1970s and 1980s. Gradually, however, supply side elements, arising from both domestic deregulation and globalisation, have risen in importance. Consider both the early period and the later period in turn, using as the basic analytical framework a global model of the traditional IS/LM sort, with a vertical real output line at full capacity.

It seems generally agreed that the rise in inflation in the ICs in the late 1960s and 1970s was a by-product of excessive demand, fuelled in many countries by expansionary monetary policies and a failure to recognise how easily inflation expectations might rise. In effect, the LM function shifted to the right, raising aggregate demand and pushing up inflation. While oil price increases are commonly thought to have arisen from supply side shocks, in fact the sharp increases in prices in the early and late 1970s were in large part discrete upward adjustments to re-establish earlier relative prices that had been eroded by generalised inflation.34 Inflation was brought down quite rapidly in the early 1980s by a sudden, sharp tightening of monetary policy. In both the expansionary phase and the contractionary phase of policy, real growth and interest rates moved in a fashion consistent with nominal forces being behind the observed outcomes. That is, inflation rose when demand exceeded potential (estimated on the basis of earlier “normal” growth rates) and fell when growth receded. Interest rates also rose as the expansion proceeded, first only in nominal terms (real rates actually fell) but then rose sharply in real terms as well. After inflation did begin to decline in the early 1980s, nominal rates fell as did real rates, but with the latter declining more slowly.

Explaining the more recent phenomenon of continuing low inflation, in spite of rapid real side growth and continuing low interest rates, demands recourse to all of the arguments above. In effect, it is necessary to postulate changes in all three functions of the model to obtain all three of the observed results. For simplicity, assume here that inflationary expectations are fixed although they would most likely be biased downwards during any period of excess supply. Begin by accepting the assumption of disinflationary pressures arising from some combination of increased domestic deregulation and competition, increased global competition and higher productivity. This provides an explanation for a rightward shift in the real output (aggregate supply function). Then consider the “saving glut” hypothesis, or perhaps more accurately the “investment strike” hypothesis. This constitutes a downward shift in the IS curve, leading to a transitional phase of output being below potential, thus accentuating the disinflationary pressures arising from supply side developments. Finally, in response to these developments, one must postulate a rightward shift in the LM function. In effect, more effective (expansionary) monetary polices lower interest rates, inducing an additional expansion of demand, determined by the slope of the IS curve, until in equilibrium aggregate demand and supply are once equal at full employment. This occurs at a higher level of output, with no further pressure on prices, and with the real interest rate at a lower level than previously.

Does this seem like a reasonable interpretation to you? And do you like the use of the IS/LM model with the full employment line?

Sunday, August 17, 2008

In case you missed it, here is the Edward Nelson-Anna J. Schwartz (N-S) paper that takes on Paul Krugman's assessment of Milton Friedman. Here is Krugman's response to N-S and, in turn, here is the N-S rejoinder to Krugman. These are gated papers at the Journal of Monetary Economics, but you can find an non-gated version of the N-S paper here.

The Economist magazine has a great article that details how the opening of U.S. health care to trade is improving it. Bringing foreign competition to this bloated sector of the U.S. economy may be just the catalyst needed to spur real reform in the U.S. health care industry. This may be globalization's big moment.

There was an interesting issue raised in the economics blogosphere last week: the end of American hegemony. Nouriel Roubini started it off with his posting "The Decline of the American Empire" where--in addition to the much ballyhooed argument that U.S. foreign policy has been misused in recent years--he noted several economic developments that point to a loss of U.S. influence. The first is the rise of other economic powers:

[R]egardless of mistaken US policies the rise of other economic and financial powers – the rise of China, the recent resurgence of Russia, the process of economic and political integration in the European Union, the emergence of India, and the rise of other regional powers such as Brazil, South Africa and Iran – implies that the relative economic, financial and geopolitical power of the US will be reduced over time.

The second and more important development, according to Roubini, is the fact that the United States has been making poor choices in economic policy:

[T]he US squandered its economic and financial power by running reckless economic policies, especially its twin fiscal and current account deficits...

The trouble with these twin deficits is multi-fold. First, superpowers and empires - like the British Empire at its peak - tend to be net lenders – i.e run current account surpluses – and be net creditors, not net debtors; The decline of the British Empire started in World War II when the British fiscal deficits in the war and the current account deficits turned that empire into a net borrower and a net debtor both in its public debt and external debt. That financial switch into an external debtor and borrower position was also the reason for the decline of the British pound as the leading reserve currency. And the British twin deficits were being financed by a rising economic and financial power that was a net lender and a net creditor, the US.

Second, the last time the US was running large twin deficits in the 1980s the main financiers of these deficits were the friends and allies of the US, i.e Japan, Germany and Europe as the US external deficit was against these economies. Today instead the economic powers financing the US twin deficits are the strategic rivals of the US – China and Russia – and unstable petro-states, i.e Saudi Arabia, the Gulf States and other shaky petro-states. This system of vendor financing – with these US creditors providing both the goods being imported and the financing of such deficits – has led to a balance of financial terror: if these creditors were to pull the plug on the financing of the US twin deficits the dollar would collapse and US interest rates would go through the roof.

Third, while it is unlikely that China, Russia and other powers would suddenly pull the rug from under the US feet – as such action would lead to a sharp appreciation of their currency and negatively affect their export led growth model – relying excessively on the kindness of strangers – especially that of your strategic rivals – is extremely risky. Since almost 100 percent of all US fiscal deficits since 2001 have been financed by non-residents... by now the total stock of US Treasuries held by non-residents is getting close to 60 percent... This change makes the US vulnerable to such rivals using the financial terror weapon – dumping US assets and or reduicing their financing of the US twin deficits – in situations of geostrategic tension.

It is worth noting that some observes believe that 'geostrategic tensions' were behind the U.S. government's bail out of Fannie and Freddie. As reported by Bloomberg, Asian investors had pressured--some would say blackmailed--Treasury Secretary Hank Paulson to bolster these institutions. The key point, though, of the above paragraphs is that Americans have themselves largely to blame should this decline of American hegemony take place.

The next day Brad Sester followed up on this issue with his post "The Changing Balance of Global Financial Power." In it, Sester notes that democratic governments are increasingly receiving their funding from authoritarian governments. He provides some interesting graphs that show how the foreign assets of the authoritarian governments now exceed and are growing faster than those of the democratic governments. He concludes with the following:

One thing is clear: the world’s biggest financial powers are no longer the world’s large democracies. A gathering of the countries that matter for global economic coordination will no longer be a gathering of the leaders of the world’s big democracies. Coordination among the large democracies was never easy — and likely will only get harder as additional countries have to be brought in.

A key implication of Sester's posting is that America's influence is on the decline. Of course, these observers are not the first ones to make the case of America's decline from an economic perspective. For example, Niall Ferguson said the following in the Financial Times earlier this year:

Future historians will look back on the current decade as a turning point comparable with that of the Seventies. No, not the 1970s. This is not going to be another piece pointing out the coincidence of an unpopular Republican president, soaring oil prices, a sagging dollar and an unwinnable faraway war. I am talking about the 1870s.

[...]

This is the story of how an over-extended empire sought to cope with an external debt crisis by selling off revenue streams to foreign investors. The empire that suffered these setbacks in the 1870s was the Ottoman empire. Today it is the US.

A key story, then, that emerges from these pieces is that America's imminent decline stems in large part from its economic profligacy. These authors are spot on regarding America's spending and saving problems, but it is not clear to me that these problems imply anything more than a temporary dip in America's hegemony status. Yes, there are huge global economic imbalances that need to be worked out, but this does not mean the fundamentals that have historically made the U.S. so economically dynamic--relatively good institutions, a strong entrepreneurial spirit, and a culture of ideas and innovation--have structurally changed. If anything, the working out of the global economic imbalances should present more problems for the China and Indias of the world where institutions are less secure and the potential for social distress is greater. Moreover, the very emergence of these new economic powers is dependent on the global public goods provided by the United States. One wonders how robust their growing influence would be in the absence of such global public goods. Roubini concedes there is uncertainty on this point:

Whether the decline of an hegemonic power providing global public goods – security, free trade, freer mobility of capital and people, inducements to free markets and democracy, better environment, peace – will lead to a more stable world with many powers multilaterally cooperating on these global economic, financial and geopolitical issues; or whether the absence of such stable hegemonic power will lead to a more unstable world characterized by conflicts – economic, political and even military – among traditional nation states, great powers and non-traditional actors is an open and difficult issue.

Nothing, of course, is certain including America's hegemony status. I, however, am just not convinced that the past 7 or so years of economic profligacy is enough to undermine the United States's superpower status.

As readers of this blog know, I am a advocate of monetary policy adopting a more nuanced view of deflation. Currently, most observers view any deflationary pressures as something to be avoided at all costs. This conventional wisdom assumes all downward price level pressures are economically harmful and, thus, fails to distinguish between between aggregate demand-induced deflationary pressures and aggregate supply-induced deflationary pressures. As a result, central bankers are likely to add monetary stimulus during periods of rapid economic growth--for example, when a positive productivity shock increases aggregate supply--in the mistaken belief that the deflationary pressures indicate economic weakness. Such actions, in turn, can generate a boom-bust cycle in economic activity. As I have argued elsewhere (here, here, here), the Fed's easy money in 2003-2005 in one such example.

Given these views of mine, I was pleased to come across Niloufar Entekhabi's new article, "Technical Change, Wage and Price Dispersion, and the Optimal Rate of Inflation." In it, Entekhabi uses a standard New Keynesian model to find the optimal rate of inflation and it turns out to be negative. One innovation of the paper is that it incorporate non-zero long-run growth in the model. From his conclusion:

This paper shows that adding real growth to the New Keynesian models is a very important feature, missing from the studies of these models. Real growth brings the arguments of price deflation rate as an optimal policy back to the policy discussion. In this research, real growth is added to a simple New Keynesian model with both price and wage rigidities. In such an environment, the economy faces four types of distortions, due to the imperfect nature of markets and the staggered contracts. Then, the Pareto optimal level of output is no longer attainable. The optimal policy is considered as the optimal rate of inflation which the central bank should target to minimize the distortions in the economy. In our experiment and under a wide range of parameter values and calibrations, this rate reveals to be slightly negative and therefore, deflation is the optimal policy... The results favor the old view in the monetary policy literature that a slight level of deflation is optimal. These results are very useful for policy analysis and show the path for the future research.

I had been meaning to do something like this paper after the reading the other New Keynesian-type analysis that also finds benign deflation might be optimal. This other paper, though, finds benign deflation to be optimal in the terms of minimizing asset boom-bust cycles. In case you missed it, here is part of my post on that research:

Lawrence Christiano, Roberto Motto, and Massimo Rostagno have a new NBER working paper titled "Two Reasons Why Money and Credit May be Useful in Monetary Policy." I find this article interesting because one of the reasons the authors cite for taking money and credit seriously in monetary policy--as opposed to standard New Keynesian analysis that sees little role for money--is that focusing "narrowly on inflation [alone] may inadvertently contribute to welfare-reducing boom-bust cycles in real and financial variables." The authors show that if (1) there are positive productivity innovations and (2) monetary policy follows a standard Taylor rule that responds to deviations of inflation from its target then boom bust cycles in asset prices can be generated.

The authors explain that in "the equilibrium with the Taylor rule, the real wage falls, while efficiency dictates that it rise [following a productivity shock]. In effect, in the Taylor rule equilibrium the markets receive a signal that the cost of labor is low, and this is part of the reason that the economy expands so strongly. The ‘correct’ signal would be sent by a high real wage, and this could be accomplished by allowing the price level to fall. However, in the monetary policy regime governed by our Taylor rule this fall in the price level is not permitted to occur: any threatened fall in the price level is met by a proactive expansion in monetary policy."

In other words, these authors are arguing that by not allowing for benign deflation--deflation generated by productivity innovations--monetary authorities are generating too much liquidity and, in turn, fueling asset price boom-bust cycles.

I hope to see many more papers like these ones on the macroeconomic implications of benign deflation. I have a few related projects in the pipeline and I believe Josh Hendrickson does as well. Maybe George Selgin and the folks at the BIS--see William White's classic "Is Price Stability Enough?"--can also push some more papers out on this topic.

Monday, August 4, 2008

Here are two studies that come to vastly different conclusions on future declines in home prices. First up is the study by Charles W. Calomiris, Stanley D. Longhofer and William Miles. Titled "Housing Turmoil", this study looks at the relationship between foreclosures and home prices. These authors find that,

[e]ven under an extreme worst-case scenario for foreclosures,... U.S. house prices just aren't going to fall by very much in the next two years. In our worst-case scenario, the average cumulative decline is about 5 percent, and only 12 states experience declines greater than 6 percent by the end of 2009.

They conclude that "declines in house prices are highly likely to remain small.... [A]s foreclosures continue to climb in many states, house prices will remain flat or decline in those states -- but will not collapse."

In the last few years, home prices had risen to unsustainable levels and then started to decline. In this paper we use a variety of techniques to assess the current extent of overvaluation. We put the most stock in the estimate based on a cointegrating relationship between the price-rent ratio and the real interest rate, which is quite robust to the choice of the sample period. According to these estimates, home prices were undervalued in the 1990s, but overshot equilibrium in 2000 and remain overvalued despite recent declines. In our best judgment, single-family home prices as measured by the OFHEO purchase-only index were around 14 percent above equilibrium in the first quarter of 2008, with a plausible range of 8 to 20 percent.

In other words, home prices may still have some ways to go. So which study is right? I find the latter study more reasonable, but I may be--and hope I am--wrong. Today's NY Times story on bigger waves of upcoming mortgage defaults from Alt-A and Prime mortgage (i.e. the good and supposedly safer mortgages) only seems to confirm Klyuev's finding. Thankfully, Arnold Kling , helps puts this housing debacle into a long-run perspective that is not so dour.

Sunday, August 3, 2008

Here is part of the Barron's interview with Roubini mentioned in the previous post. In this excerpt Roubini discusses how the government bailout of Wall Street should have had more bailing in of the creditors and investors. This approach would prevent systematic failure of the financial system without socializing the losses of Wall Street.

...How do you think Federal Reserve Chairman Ben Bernanke has handled the crisis so far?

The Fed's performance has been poor. More than a year ago the Fed said the housing slump would end, but it hasn't. They kept repeating this was a subprime-debt problem only, whereas the problems of excessive credit involve subprime, near-prime, prime, commercial real estate, credit cards, auto loans, student loans, home-equity loans, leveraged loans, muni bonds, corporate loans -- you name it.

The Fed's other mistake was to believe the collapse of the housing market would have no effect on the rest of the economy, when housing accounted for a third of all job creation in the past few years. When the proverbial stuff started to hit the fan last summer, the Fed went into aggressive-easing mode. But it has always been kind of catching up.

What should Bernanke have done a year ago, or even prior to that?

The damage was done earlier, beginning when the Greenspan Fed lowered interest rates in 2001 after the bust of the technology bubble, and kept them too low for too long. They kept cutting the federal funds rate all the way to 1% through 2004, and then raised it gradually instead of quickly. This fed the credit and housing bubble.

Also, the Fed and other regulators took a reckless approach to regulating the financial sector. It was the laissez-faire approach of the Bush administration, and (tantamount to) self-regulation, which really means no regulation and a lack of market discipline. The banks' and brokers' risk-management models didn't make sense because no one listens to the risk managers in good times. As Chuck Prince (the deposed CEO of Citigroup) said, 'when the music plays you have to dance.'

Now the regulators are attempting to make up for lost time. What do you think of their efforts?

The paradox is they're going to the opposite pole. They are overregulating, bailing out troubled participants and intervening in every market. The Securities and Exchange Commission has accused others of trying to manipulate stocks, but the government itself is now the manipulator. The regulators should investigate themselves for bailing out Fannie Mae (FNM) and Freddie Mac (FRE), the creditors of Bear Stearns and the financial system with new lending facilities. They have swapped U.S. Treasury bonds for toxic securities. It is privatizing the gains and profits, and socializing the losses, as usual. This is socialism for Wall Street and the rich.

So the government should have let Bear Stearns fail, not to mention Fannie and Freddie?

If you let Bear Stearns fail you can have a run on the entire banking system. But there are ways to manage Bear or Fannie and Freddie in a fairer way. If public money is to be put at stake, first all the shareholders of these companies have to be wiped out. Management has to be wiped out, and the creditors of Bear should have taken a hit. Why did the Fed buy $29 billion of the most toxic securities, and essentially bail out JPMorgan Chase (JPM), which bought Bear Stearns?

Because JPMorgan was a counter-party?

Exactly. The government bailed out everyone. Even the unsecured creditors of Fannie and Freddie should have taken a hit. Sometimes it is necessary to use public money to rescue institutions, but you do it in a way in which you're not bailing out those who made the mistakes. In each one of these episodes the government bailed out the shareholders, the bondholders and to some degree, management.

LIKE THE EXHORTATIONS OF JEREMIAH TO THE NATION OF Israel before the first temple's destruction, the warnings of economist Nouriel Roubini fell on deaf ears. For the past two years Roubini, a professor at New York University, has cautioned about a huge housing bubble whose bursting would lead to a 20% drop in home prices; a collapse in subprime mortgages; a severe banking crisis and credit crunch; the near-failure of Fannie Mae and Freddie Mac, and a U.S. recession of a magnitude not seen since the Great Depression. So far, this latter-day prophet of doom has been on the mark, though time will tell about the recession part.

I love the prophet Jeremiah analogy. I wonder, though, if the Biblical character Joseph would be a better comparison for Roubini. After all, both were taken from their home lands (Canaan, Turkey/Italy) , educated in at the finest centers of learning of their time (Egypt, Harvard), and warned that the good economic times would be followed economic bust (7 years of abundance-7 years of famine, 4 years of housing boom, 2 -3 years of housing bust and residual fallout). Joseph, of course, was better at calling the turning point and had a longer forecast horizon, but I think he still makes a better comparison than Jeremiah. What do you think?

Friday, August 1, 2008

Michael Owyang, Jeremy Piger, and Howard Wall have a paper that takes a fresh look at the "Great Moderation", the reduction in aggregate macroeconomic volatility since the early 1980s. This Great Moderation has received a lot of attention--including from this blog(here and here)--with a lot of it directed to explaining why the volatility has declined . These authors make a novel contribution to this literature by looking at this issue from the state level. Their paper, titled "A State-Level Analysis of the Great Moderation", points to better monetary policy as a key factor behind the reduced macroeconomic volatility. Here are the authors in their own words:

This paper documented the Great Moderation at the state level and found significant heterogeneity in the timing and magnitude of states’ structural breaks. Specifically, we found that 38 states experienced a structural break and that 14 states had breaks that occurred at least three years before or after the aggregate break, which we place at September 1984. The states for which we found weak or little evidence of a break tended to be along the Atlantic coast.

Typically, when macroeconomists are looking for explanations for the Great Moderation, they have only the single aggregate occurrence with which to work. As a result, severalhypotheses have gained support on the basis of temporal coincidence between various events or trends and this single volatility reduction. Unfortunately for this approach, however, a surfeit of events occurred alongside the Great Moderation, so it is difficult to sort out the many theoretically plausible explanations. Our set of state-level great moderations might, therefore, be useful in sorting through the various hypotheses.

Of the five main hypotheses that have been put forth, our results suggest that four of them—the inventory, good-luck, banking deregulation, and demography hypotheses—are implausible because they are statistically inconsistent with the state-level pattern of structural breaks. On the other hand, we found that the monetary hypothesis remains a plausible explanation of the Great Moderation in that it is not inconsistent with the state-level experience.